The purpose of this study is to determine financial development levels that enhance export diversification via innovation. While innovation can diversify exports, the critical threshold at which financial development may enhance the relationship remains ambiguous. This study will use the panel smooth transition regression (PSTR) model to investigate the nonlinear link between innovation and export diversification, with a focus on financial development. The model simplifies the identification of an endogenous threshold that separates nations into financial development regimes and forecasts the impact of innovation on export diversification within these regimes.
The paper has used a PSTR model with the transition variable of the level of financial development. Basically, the PSTR model assumes parameters to change smoothly as the function of a threshold variable. First, the hypothesis of the linear model is tested against the non-linear hypothesis. Fischer LM test, Wald test and likelihood ratio are used to test the nonlinearity. This study adheres to the procedures proposed by Fouquau et al. (2008) and Colletaz and Hurlin (2006) to estimate the parameters of the PSTR model and perform the tests mentioned above.
The results demonstrate that financial development is a crucial mediator linking innovation to export diversification. At lower levels of financial development, an increase in the innovation index is accompanied by a decrease in export diversification, indicating that in the context of low financial development, innovation fails to translate into export diversification. However, beyond a certain level of financial development, innovation has a positive impact on export diversification, highlighting its critical role in facilitating the expansion of export diversification.
This study, like any other empirical research, has its limitations. First, it uses a principal component analysis (PCA)-based innovation index to examine how innovation affects export diversification. This study examines the robustness of the results only within the panel generalized method of moments (GMM) framework and does not use an alternative general innovation measure in the PSTR model to further test robustness. Second, while the panel GMM model addresses potential endogeneity and causal inference concerns, these issues remain unresolved in the PSTR framework. Future research could tackle these limitations within the PSTR context.
It is imperative that pertinent policies must be customized to the specific stage of financial development. In the initial stages, the primary focus should be on promoting financial inclusion and innovation in new export sectors. This can be achieved by encouraging firms to invest in research and development, collaborate with research institutions, or leverage intellectual property rights to improve their competitiveness in global markets. In the later stages, the focus should be on fostering innovation ecosystems, facilitating the internationalization of innovative firms, and ensuring a robust financial system.
According to the research findings, policymakers in countries with lower financial development should adopt policies such as credit guarantees, public innovation funds, institutional support for small and medium-sized enterprises, infrastructure investments, productivity enhancement and attracting foreign direct investment to reduce financial barriers, foster innovation and promote export diversification. In countries with higher financial development, policymakers can promote innovative activities and programs that increase productivity, increase gross domestic product per capita and encourage currency depreciation to improve export diversification while providing export-related tax incentives.
The paper contributes to the literature on innovation and export performances in four ways: it emphasizes that diversity in exports – volumes, intensities, quantities and markets – is a better indicator of export performance; it challenges the linearity assumption typically made about innovation and exports, pointing to the role of financial development in moderating that association; it endogenously categorizing the various financial development regimes to help address the contradictory findings on innovation impacts; and finally, it introduces an innovation index – the kind that can be developed through PCA and encompass patents, trademarks and R&D data rather than a mere measure of innovation.
